Credit Crisis: Foundations
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  1. Credit Crisis: Introduction
  2. Credit Crisis: Wall Street History
  3. Credit Crisis: Historical Crises
  4. Credit Crisis: Foundations
  5. Credit Crisis: What Caused The Crisis?
  6. Credit Crisis: Bird's Eye View
  7. Credit Crisis: Government Response
  8. Credit Crisis: Market Effects
  9. Credit Crisis: Lessons Learned
  10. Credit Crisis: Conclusion
Credit Crisis: Foundations

Credit Crisis: Foundations

By Brian Perry



At the dawn of the new millennium, global financial markets entered a period that came to be defined by low interest rates and below-average volatility. This period, sometimes referred to as "the great moderation", was characterized by a global savings glut that saw emerging-market and oil-producing countries supply the developed world with enormous amounts of capital. This capital helped keep interest rates at historically low levels in much of the developed world and prompted investors to seek out new investment opportunities in a search of higher yields than those available in traditional asset classes. This search for yield eventually led to an increased willingness among some market participants to accept greater levels of risk for lower levels of compensation.

This increased willingness to accept risk combined with excessive leverage, a housing bull market and widespread securitization would sow the seeds of the 2008 financial crisis. The remainder of this chapter will take a closer look at this greater willingness to accept risk, as well as the increased use of leverage, home price appreciation and securitization.


Risk
As the global savings glut contributed to extremely low interest rates in many traditional asset classes, investors sought higher returns wherever they could find them. Asset classes such as emerging market stocks, private equity, real estate and hedge funds became increasingly popular. In many instances, investors also found above-average returns in staggeringly complex fixed-income securities. (For more on this, see Structured Products Too Complex For The Average Joe.)

This global search for yield was prompted not only by historically low interest rates, but also by very low levels of volatility in many financial markets. These low levels of volatility made many risky asset classes appear safer than they actually were. Computerized models used to price complicated fixed-income securities assumed a continuing low-volatility environment and moderate price movements. This mispricing of risk contributed to inflated asset values and much greater market exposures than originally intended.

Leverage
The use of leverage can enhance returns and does not appear to carry much additional risk during periods of low volatility. The "great moderation" featured two forms of leverage. Investors used derivatives, structured products and short-term borrowing to control far larger positions than their asset bases would have otherwise allowed. At the same time, consumers made increasing use of leverage in the form of easy credit to make possible a lifestyle that would have otherwise exceeded their means.

The early parts of the decade provided a near-perfect environment for this increasing use of leverage. Low interest rates and minimal volatility allowed investors to employ leverage to magnify otherwise subpar returns without exposure to excessive risk levels (or so it seemed). Consumers also found the environment conducive for increasing their use of leverage. Low interest rates and lax lending standards facilitated the expansion of a consumer credit bubble. In the U.S., the savings ratio (a good approximation of how much use consumers are making of leverage) dropped from nearly 8% in the 1990s to less than 1% in the years leading up to the credit crisis. (For related reading, see Credit Cards: The Birth Of A Plastic Empire.)

As long as interest rates and volatility remained low and credit was easily available, there seemed to be no end in sight to the era of leverage. But the increased use of leverage and increasing indebtedness were placing consumers in a dangerous situation. At the same time, higher leverage ratios and an increasing willingness to accept risk were creating a scenario in which investors had priced financial markets for a near-perfect future. (For more on leveraging, see Put An End To Everyday Debt.)

Housing
To understand what happened in the housing market, we need to step back in time to the aftermath of the tech bubble and stock market meltdown of 2000-02. The precipitous decline in the stock market, combined with the accompanying recession and the terrorist attacks of September 11, 2001, caused the Federal Reserve (the Fed) to lower the federal funds rate to an unprecedented 1%. The economy and stock market did recover, but the slow pace of economic expansion prompted the Fed to maintain unusually low interest rates for an extended period of time. This sustained period of low interest rates accomplished the Fed's objectives, but they also contributed to a huge boom in the housing market.

As housing prices soared in many areas of the country, mortgage providers offered a variety of creative products designed to help buyers to afford more expensive homes. At the same time, lenders relaxed underwriting standards, allowing more marginal buyers to receive mortgages. The combination of low interest rates and easy access to credit prompted a dramatic increase in the value of homes. Consumers have historically believed that home prices do not decline, and that buying a home is one of the best investments they can make. The soaring housing market reinforced these beliefs and prompted a rush among consumers to buy a house as quickly as possible before prices rose even further. Many people also began speculating in the housing market by purchasing homes in the hope of "flipping" them quickly for a profit.

As home prices continued to soar, the market began to take on all of the characteristics of a classic bubble. (For more on this, read Why Housing Market Bubbles Pop.)

Securitization
Securitization describes the process of pooling financial assets and turning them into tradable securities. The first products to be securitized were home mortgages, and these were followed by commercial mortgages, credit card receivables, auto loans, student loans and many other financial assets.

Securitization provides several benefits to market participants and the economy including:

  1. Providing financial institutions with a mechanism to remove assets from their balance sheets and increasing the available pool of capital
Lowering interest rates on loans and mortgages

  • Increasing liquidity in a variety of previously illiquid financial products by turning them into tradable assets
  • Spreading the ownership of risk and allowing for greater ability to diversify risk
  • In addition to its benefits, securitization has two drawbacks. The first is that it results in lenders that do not hold the loans they make on their own balance sheets. This "originate to distribute" business model puts less of an impetus on lenders to ensure that borrowers can eventually repay their debts and therefore lowers credit standards. The second problem lies with securitization's distribution of risk among a wider variety of investors. During normal cycles, this is one of securitization's benefits, but during times of crisis the distribution of risk also results in more widespread losses than otherwise would have occurred.

    In the years leading up to the credit crisis, investors searching for yield often focused on securitized products that seemed to offer an attractive combination of high yields and low risk. As long as home prices stayed relatively stable and home owners continued to pay their mortgages, there seemed to be little reason not to purchase 'AAA'-rated securitized products. (For further reading, see Investing In Securitized Products.)

    Conclusion
    The "great moderation" of the early part of the 2000-2010 decade led investors to assume greater levels of risk and employ higher levels of leverage. The low interest rates of this period also contributed to a housing bubble and an increased willingness by consumers to take on more debt. At the same time, the widespread use of securitization meant that the risk from home mortgages and many other loans was spread throughout the economy. The combination of an increased willingness to assume risk, excessive leverage, a housing bubble and widespread securitization created the perfect environment for the credit crisis to occur.

    Credit Crisis: What Caused The Crisis?

    1. Credit Crisis: Introduction
    2. Credit Crisis: Wall Street History
    3. Credit Crisis: Historical Crises
    4. Credit Crisis: Foundations
    5. Credit Crisis: What Caused The Crisis?
    6. Credit Crisis: Bird's Eye View
    7. Credit Crisis: Government Response
    8. Credit Crisis: Market Effects
    9. Credit Crisis: Lessons Learned
    10. Credit Crisis: Conclusion
    Credit Crisis: Foundations
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